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529 vs. UTMA: Which College Savings Plan Is Right for You?

529 plans and UTMA (Uniform Transfers to Minors Act) accounts are popular education savings accounts.

A 529 plan is an education savings account designed to pay for college tuition and other qualified expenses, such as room and board, books, and technology. The funds in these plans grow tax-free, and the withdrawals for qualified educational expenses are also tax-free.

On the other hand, a UTMA account is a custodial account that can be used for any purpose that benefits the child, not just education-related expenses. Earnings in UTMA accounts are typically taxed at the child’s rate, which is often lower than the parent’s rate.

529 plans offer several advantages over UTMA accounts, including tax benefits and more control over how the funds are used. However, UTMA accounts can be more flexible and provide more investment options.

But which one’s best for your family?

In this article, we’ll explore the differences between 529 plans and UTMA accounts. We’ll cover some key factors to consider when choosing between the two and provide tips for maximizing your savings and investments.

 

Key Take Aways

  • 529 plans offer tax-free growth and withdrawals for education expenses but are more limited in how funds can be spent.
  • UTMA accounts provide more flexibility in how the funds can be spent and offer a broader range of investments but have fewer tax advantages than 529 plans.
  • The best education savings account will depend on your financial goals and needs.

 

What is a 529 Plan?

529 Plans, a.k.a. Qualified Tuition Programs, are tax-advantaged investment accounts designed to help you save for anyone’s future educational expenses. It was established in 1996 based on section 529 of the Internal Revenue Code, hence the term “529 plan.”

There are two types of 529 plans:

  • 529 Pre-paid Tuition Plans: These allow individuals to prepay future tuition at current rates by purchasing units redeemable at US colleges or universities. These prepaid units are locked in and are guaranteed to cover tuition and fees at eligible schools regardless of whether college costs increase. The contributed funds are pooled and invested by the state or institution, so you have no control over the investments.
  • 529 Savings Plans: These allow individuals to contribute cash to an education savings account, which you can use at most colleges and universities nationwide. These are investment accounts that can invest in ready-made portfolios or choose from a limited selection of investment funds, such as mutual funds or exchange-traded funds (ETFs), to grow your savings over time.

Unlike prepaid tuition plans, 529 savings plans do not lock in tuition rates. They’re also not state-guaranteed investments.

However, flexibility is an advantage of 529 savings plans over 529 pre-paid tuition plans. Currently, 529 Pre-paid Tuition Plans are only available in FL, IL, MD, MA, MI, NV, PA, TX, VA, and WA. At the same time, 529 savings plans are offered to schools nationwide (and sometimes internationally).

Another advantage of savings plans over pre-paid tuition plans is that you can dictate how much you contribute to the account. With a prepaid tuition plan, you pay for a specific amount of tuition in one lump sum or through installment payments.

 

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Pros of 529 Plan

 

Tax Deferred

Contributions to Section 529 are funded with after-tax dollars and grow tax-deferred. That means earnings from the investment are not reduced by annual income taxes or capital gains taxes.

This tax advantage translates to significant savings over time as you don’t have to worry about taxes cutting into your investment return. Because the money grows tax-free, your earnings in the account may grow faster than your outside investments, like a mutual fund.

 

Tax Deductions

Your state might offer you tax deductions or credits for contributions to 529 plans.

Remember that many states that offer tax deductions require you to invest in your state’s plan. States that don’t have a state income tax (AK, FL, NV, NH, SD, TN, TX, WA, and WY) cannot give you a state tax deduction or credit.

 

Tax-Free Earnings on Qualified Expenses

Withdrawals on 529 accounts are tax-free for qualified educational expenses up to the amount determined by the institution as part of the cost of attendance. Qualified educational expenses include tuition, fees, books, and room and board. Some examples of ineligible expenses are health insurance, transportation, or student loan payments.

Though the focus of 529 plans is on paying for college, starting in 2018, you can withdraw up to $10,000 per child without incurring federal tax penalties to pay for tuition at a private school. (Note that not every state conforms to this rule, and some states, such as California, will tax you on withdrawals used to pay for K-12 tuition).

 

High Contribution Limits

Another advantage is the high contribution limits, which allow for substantial savings. Specific contribution limits vary from state to state, but the amount can be upwards of $500,000. (Check your state to verify the maximum amount you can contribute and the age limit for beneficiaries.) You must file a gift tax return if you contribute more than the annual gift limit ($17,000 in 2023) to a beneficiary’s 529 plan.

 

Asset Protection

Many states have statutes that specifically protect the account from the creditors of the owner, beneficiary, and other contributors to the account. Maximal protection is available in Colorado, Florida, Illinois, South Dakota, and Virginia. Remember that asset protection law is always state-specific.

 

Flexibility

One key advantage of 529 plans is the flexibility they offer. Suppose the plan’s beneficiary decides not to attend college or receives a scholarship. In that case, a plan owner can rollover funds tax-free into a 529 plan created for another family member of the current beneficiary. Family members are defined very broadly and also include the plan owner. If you rollover the plan to someone not a family member of the current beneficiary, there will be penalties on the rollover.

It’s important to note that each state may have different rules and benefits for its 529 plans, so it’s crucial to research and compare the options available in your state and other states before choosing a plan that best suits your needs and goals.

You might also like: What to Consider Before Doing a 529 Plan Rollover

 

Cons of 529 Plan

 

Penalties and Fees

Distributions from 529 accounts consist of after-tax contributions and earnings. The earnings portion is not taxed if used to pay for qualified education expenses.

However, any money distributed for any purpose other than education is subject to taxes and a 10% penalty on the earnings portion of the distribution, not on the principal. Many states also charge additional penalties on nonqualified withdrawals.

Money distributed for purposes other than education is taxed ordinary income at the account owner’s income tax bracket. Still, some 529 plans allow the withdrawal to be directed to a beneficiary in a lower tax bracket than the owner.

If you’re wondering what to do if you overcontribute or if it’s possible to use your 529 Account for retirement savings, we wrote an article about that here.

 

Limited Investment Options:

529 savings plans offer ready-made portfolios. Most 529 savings plans offer a limited selection of mutual funds. It’s common to see age-based funds included in the investment options. These funds invest in riskier investments like stocks when the child is young but switch to more conservative investments such as bonds and cash as the child ages.

Prepaid plans do not have individual investment accounts. Instead, your contributions go into a general fund, which the plan’s money manager manages to meet its future obligations to its participants.

 

Fees and Expenses

Another potential issue is that some state-sponsored 529 plans have fees and expenses impacting investment returns.

529 savings plans may charge fees for administration, investment management, and other costs. Research and compare plans (consider looking from a different state) before investing to ensure you make the best choice.

 

Related Read: 529 Plans: What You Need to Know About College Savings

 

Who Can Open a 529 Plan?

Anyone can open a 529 on another’s behalf. That means you can be someone’s parent and be a non-parent and open one on anyone’s behalf, as long as you’re a U.S. taxpayer.

You can also open one on your behalf. For instance, if you plan to have children and want to get a head start on your college savings, you can name yourself the beneficiary and change it later.

 

 

What is a UTMA Account?

A UTMA account, or Uniform Transfers to Minors Act account, is a custodial account designed to hold and manage assets for the benefit of a minor. In a custodial account, the contributor makes an irrevocable gift to a minor, who is the beneficiary.

When you open a UTMA account, you act as the custodian, managing the assets on behalf of the minor until they reach the state’s legal age, typically 21 or 25, depending on the state. In some states, the minor receives control of the funds at age 18.

 

Pros of UTMA Accounts:

 

Greater Investment Options

One advantage of UTMA accounts is that they allow for greater investment options, including stocks, bonds, mutual funds, real estate, and oil and gas interests. This could offer higher returns in comparison to traditional savings accounts.

 

Lower Tax Rates

The first $2,200 of earnings and capital gains in a UTMA account are subject to taxes at the minor’s tax rate, regardless of whether they remain in the account or are distributed to the child. This is advantageous because the child’s tax rate is usually lower than the parents. After the first $2,200, the earnings are taxed at the parent’s income tax rate.

 

Flexible

Unlike a 529 plan, UTMA accounts have no restrictions on how the funds can be used as long as they benefit the child. This means you can use the funds for non-education-related expenses such as medical bills or a down payment on a house, providing more flexibility in financial planning for the child’s future.

 

Cons of UTMA Accounts:

 

Beneficiary Has Full Control

With a UTMA account, the beneficiary gets full control of the account when they reach the age of majority to use the funds for any purpose. While this offers more flexibility than a 529 plan, you don’t control how the money is spent.

 

Cannot Change Beneficiaries

You cannot transfer a UTMA account to another individual or change beneficiaries.

 

Negative Impact on Financial Aid

Since the money and assets in a UTMA account is considered the minor’s assets, it could reduce their eligibility for need-based financial aid. The FAFSA calculation looks at assets available to pay for college. The calculation assumes that 20% of the child’s assets are available to pay for school while only 5.64% of the parent’s assets are assumed to be available to pay for higher education expenses for the child.

 

529 Plan vs. UTMA Summary Table:

 

Infographic
Image credit: www.physicianonfire.com

 

529 Plan vs. UTMA: Making the Right Choice

When deciding between a 529 plan and a UTMA account for college savings, it’s essential to consider various factors. Here are some key points covered above:

 

Tax Benefits

529 plans offer tax-deferred growth and tax-free withdrawals for qualified education expenses.

In contrast, the tax treatment of UTMA accounts depends on the child’s income. UTMA accounts are subject to the child’s tax rate for the first $2,200 earnings. After that, the income is subject to the parent’s tax rate.

 

Flexibility

UTMA accounts can be used for any purpose that benefits the child, whereas 529 funds must be used for qualified education expenses.

 

Investment Choices

While 529 plans offer a range of investment options, it’s generally limited compared to UTMA accounts. If you’re looking for a more tailored and flexible investment strategy, a UTMA might be a better option than a 529 plan.

 

Control

With a 529 plan, you retain control over the assets even after the beneficiary reaches legal age. The account owner for 529 can also change the beneficiary as needed. Conversely, with UTMA, the child gains full control once they reaches the state’s age of majority.

 

Impact on Financial Aid Eligibility

Assets in a UTMA account can have a greater impact on your child’s financial aid eligibility than a 529 plan. UTMA accounts are considered the child’s assets, which can significantly decrease the financial aid money the child is eligible to receive. Generally, 529s do better regarding financial aid because the assets in a 529 plan are considered parental assets.

 

Final Thoughts

When deciding between a 529 plan and a UTMA account for college savings, it’s essential to consider your specific financial goals and needs.

For instance, if your primary goal is to save for your child’s college education, a 529 plan generally offers more tax benefits but has limited investment options.

However, if you anticipate needing flexibility on how the funds can be used – for example, if your child decides not to attend college, a UTMA account could be a better choice. However, this flexibility should be weighed against the potential tax consequences of investment income in a UTMA account.

Consider your family’s unique financial situation and goals when choosing between the two options. Both plans can offer valuable benefits, but selecting the one that best aligns with your objectives and maximizes your child’s educational opportunities is crucial.

 

Frequently Asked Questions:

 

What are the tax benefits of 529 plans compared to UTMA accounts?

529 plans offer tax-deferred growth, allowing your money to grow without paying taxes. When you withdraw funds for qualified education expenses, the earnings are tax-free. UTMA accounts, on the other hand, do not provide the same tax advantages. While initial contributions are considered gifts and not subject to taxes, any earnings above a certain threshold may be subject to the “kiddie tax” on the child’s tax return.

 

How do withdrawal rules differ between 529 plans and UTMA accounts?

Withdrawals from a 529 plan must be used for qualified education expenses to avoid taxes and penalties. These qualified expenses include tuition, fees, books, and room and board costs. UTMA accounts provide more flexibility, as the funds can be used for any purpose that benefits the child, not just education-related expenses.

 

Can funds from a UTMA account be transferred to a 529 plan?

You can transfer funds from a UTMA account to a 529 plan. However, this transfer is considered a custodial 529 plan, meaning the account must be managed for the child’s benefit, and the funds must be used for education expenses. Transferring UTMA funds to a 529 plan may have tax implications, so consult a tax advisor before switching.

 

What are the critical differences between UGMA and UTMA accounts?

UGMA and UTMA accounts are custodial accounts meant to hold and manage assets for minors. The main difference between the two lies in the types of assets they can hold. UGMA accounts are limited to financial assets like cash, stocks, and bonds. UTMA accounts, on the other hand, can have a broader range of assets, including real estate, intellectual property, and art.

 

How do state variations impact UTMA and 529 plan options?

State variations can affect the availability of certain tax benefits and the investment options provided by 529 plans and UTMA accounts. Some states offer tax deductions or credits for contributions to a 529 plan, while others may not. UTMA accounts are subject to state law, which may influence the age at which the account ownership transfers to the child. It is important to research the specific rules and options available in your state when deciding between a 529 plan or a UTMA account.

 

Which account is better for saving for education: 529 plan or UTMA account?

If your primary goal is saving for education expenses, a 529 plan is generally a better option due to the tax benefits and focus on education-related expenses. However, if you require more flexibility in how the funds will be used or want the ability to hold a broader range of assets, a UTMA account may be more suitable. Consider your specific financial situation, goals, and state laws when deciding. source

 

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3 thoughts on “529 vs. UTMA: Which College Savings Plan Is Right for You?”

  1. Hoping you can learn some insight into this, which I find frustrating nobody has considered/ gone into the weeds for.

    The huge disadvantage I see 2529 plan, is that you have to use it the years your child starts college. What if the market goes down that year or next 4? It’s not like you can claim it later like an HSA.

    Second consideration: what if you transferred your most appreciated stocks into your child’s UTMA account to pay for tuition that year? Is my thinking correct that you would essentially pay zero tax on the capital gains? Similar thoughts for paying for anything your child needs further down the line, such as a wedding, etc.. is my thinking correct?

    Thanks!

    Reply
    • When a giftee sells a stock an appreciated stock that was given to them, the basis is the gifter’s original cost basis, so the child would have the same capital gains as the parent would have. Additionally, any unearned income over $2,200 is taxed at the parent’s tax rate for children subject to the kiddie tax.

      Reply
      • Sorry, should’ve prefaced this line of thought with the assumption that your child is earning very little income at this point in their early lives/in college and would essentially be in the 0% tax bracket for capital gains….. I was dictating my original post on the phone quickly. I forgot about the kiddie tax…. bummer, your’e right.

        I suppose though, say we were paying for a wedding or schooling for a child above 24 years of age, would this be ok?

        Wouldn’t a clever scenario be to gift your most appreciated fund to help pay for a child’s wedding, and then buy the same fund rather than paying cash?

        Reply

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